Managing Capital Market Frictions via Cost-Reduction Investments

40 Pages Posted: 9 Jan 2018 Last revised: 12 Apr 2019

See all articles by Fehmi Tanrisever

Fehmi Tanrisever

Bilkent University, Faculty of Business Administration

Nitin Joglekar

Boston University - Questrom School of Business

Sinan Erzurumlu

Babson College

Moren Levesque

York University

Date Written: January 1, 2018

Abstract

This research explores a firm’s process investment decision to reduce its unit production cost in the presence of capital market frictions, prior to making a production decision. This investment depletes the firm’s risk-free assets and creates two potentially counteracting effects: an operational effect associated with unit production cost reduction and a friction effect that captures the change in financing costs when the firm has to borrow money. Based on interactions of these two effects, we find parametric conditions when investment is optimal and show that the benefit from investing in cost reductions may increase with the level of market frictions, particularly, when the firm’s initial unit cost and capital are both sufficiently low and the investment’s impact on the unit cost is sufficiently high. We further find that technology uncertainty mitigates the impact of market friction on the benefit of investing, whereas demand uncertainty increases the feasible parameter space where the investment is optimal.

Suggested Citation

Tanrisever, Fehmi and Joglekar, Nitin and Erzurumlu, Sinan and Levesque, Moren, Managing Capital Market Frictions via Cost-Reduction Investments (January 1, 2018). Available at SSRN: https://ssrn.com/abstract=3095186 or http://dx.doi.org/10.2139/ssrn.3095186

Fehmi Tanrisever (Contact Author)

Bilkent University, Faculty of Business Administration ( email )

Bilkent
Ankara, 06800
Turkey

Nitin Joglekar

Boston University - Questrom School of Business ( email )

595 Commonwealth Ave
Boston, MA 02466
United States

Sinan Erzurumlu

Babson College ( email )

231 Forest St.
Babson Park, MA 02457-0310
United States

Moren Levesque

York University ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

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